CHAPTER-SEVEN

REINSURANCE
Reinsurance is another important insurance operation. This section discusses the
meaning of reinsurance, the reasons, for reinsurance, and the different types of
reinsurance contracts.
There are many risks in all classes of business which are too great for one insurer to bear
solely on his won account. Reinsurance is a method created to divide the task of
handling risk among several insurers. Naturally, the insuring public wishes to effect
cover with one insurer and the insurer who in these circumstances all or part of the risk
with other direct insurers or with companies which transact reinsurance business only.
Reinsurance may be defines as the shifting by a primary insurer, called the ceding
company, of a part of the risk it assumes to another company, called the re insurer. That
portion of risk kept by the ceding company is known as the line, or retention, and varies
with the financial position of the insurer and the nature of the exposure. When a re
insurer passes on risks to another re insurer, the process is known as retrocession. It is
not good business to refuse to write insurance in excess of the retention amount. Imaging
the displeasure of the applicant, particularly of the producer when the application is
rejected or accepted in part. For theses and other reasons insurers commonly insure that
portion of their liability under their contract in excess of their retention with one or more
insurers. This process is called reinsurance, the originating insurer is the “primary
insurer”, or “direct insurer”, and the accepting insurer is the “re insurer”.
Reasons for Reinsurance
Reinsurance is used for several reasons. The most important reasons include the
following: Increase underwriting capacity, Stabilize profits, Reduce the unearned
premium reserve and Provide protection against a catastrophic loss.
Increase underwriting capacity: Reinsurance can be used to increase the insurance
company’s underwriting capacity to write new business. The company may be asked to
assume liability for losses in excess of its retention limit. Without reinsurance, the agent
would have to place large amounts of insurance with several companies or not accept the
risk. This is awkward and may create ill will on behalf of the policy owner. Reinsurance
permits the primary company to issue a single policy in excess of its retention.

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Stabilize Profits
Reinsurance can be used to stabilize profits. An insurer may wish to avoid large
fluctuations in annual financial results. Loss experience can fluctuate widely because of
social and economic conditions, natural disasters, and chance. Reinsurance can be used
to level out the effects of poor loss experience. For example, reinsurance may be used to
cover a large exposure. If a large, unexpected loss occurs, the re insurer would pay the
portion of the loss in excess of some specified limit. Another arrangement would be to
have to re insurer reimburse the ceding insurer for loses that exceed a specified loss ratio
during a given year. For example an insurer may wish to stabilize its loss ratio 70%. The
re insurer then agrees to reimburse the ceding insurer for part or all the losses in excess of
70% up to some maximum limit.
Reduce the unearned premium reserve
Reinsurance can be used to reduce the unearned premium reserve. For some insurers,
especially newer and smaller ones, the ability to write large amounts of new insurance
may be restricted by the unearned premium reserve requirement. The unearned premium
reserve is a liability item on the insurer’s balance sheet that represents the unearned
portion of gross premiums on all outstanding policies at the time of valuation. If effect,
the unearned premium reserve reflects the fact that premium are paid in advance, but the
period of protection has not yet expired. As time goes on, part of the premium is
considered earned, while the remainder is unearned. It is only after the period of
protection has expired that the premium is fully earned.
Provide Protection Against a Catastrophic Loss
Reinsurance also provides financial protection against a catastrophic loss. Insurers
experience catastrophic losses because of natural disasters, industrial explosions,
commercial airline disasters, and similar events. Reinsurance can provide considerable
protection to the ceding com-any that experiences a catastrophic loss. The reinsure pays
part of loss that exceeds the ceding company’s retention up to some specified maximum
limit.

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Other Reasons for Reinsurance
An insurer can use reinsurance to retire form the business or from a given line of
insurance or territory. Reinsurance permits the insurer’s liabilities for existing insurance
to be transferred to another carrier; thus, the policy owner’s coverage remains
undisturbed.
Methods of Reinsurance
There are two main methods in which risks can be shared:
 Facultative Reinsurance
 Automatic Treaty.
Facultative Reinsurance
Facultative reinsurance is reinsurance on an optional basis. There is no advance
agreement between the ceding company and the re insurer regarding the sharing of risks
and premiums. Under this arrangement a primary insurer, in considering the acceptance
of a certain risk, shops around for reinsurance on it, attempting to negotiate coverage
specifically only this particular contract. Each risk, which it offered, is described and this
is shown to the prospective re insurers who are offered, is described and this is shown to
the prospective re insurers who are free to accept or decline as they see fit. A life
insurers, for example may receive an application for birr 1 million of life insurance on a
single life. Not whishing to reject this business, but still unwilling to accept the entire
risk, the primary insurer communicates full details on this application to another insurer
with whom it has done business in a past. The other insurer may agree to assume 40% of
any loss for a corresponding percentage of the premium. The primary insurer then puts
the contract in force.
The reinsurance agreement does not affect the insured in any way. The insured is
generally not aware of the reinsurance process and the primary insurer remains fully
liable to the insured in event of loss.
As stated earlier the insurer retains the right to decide whether and how much of his risk
to submit for reinsurance. The re insurer also retains the right to accept or reject any
business offered by the insurer.

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Automatic Treaty
Under an automatic reinsurance treaty the ceding insurer agrees to pass on to the re-
insurer all business included within the scope of treaty, the re insurer agrees to accept this
business, and the terms e.g., the premium rates and the method of sharing the insurance
and the losses of the agreement are set. The ceding company is required to cede some
certain amounts of business, and the re insurer is required to accept him. The ceding
company known in advance that it will be able to obtain reinsurance for all exposures that
meet the conditions specified in the treaty. The amount that the ceding company keeps
for its own account is known as its retention, and the amount ceded to other is known as
cession.
Forms of Reinsurance Treaties:
The most important types of reinsurance treaties include:
 Quota-share reinsurance.
 Surplus-share reinsurance.
 Excess of loss reinsurance.
Quota-share reinsurance: Quota share reinsurance method the direct office arranges
with reinsures to cede a fixed proportion of all its business of a certain class and the re
insurer accepts that proportion in return for a corresponding proportion of the premiums.
Under quota share split, the insurance and loss are shares according to some pre-agreed
percentage. For example, if a 100,000 birr policy is written and the agreed split is 50-50,
the re insurer assumes on half of the liability; the insurer and the re-insurer each pays
one-half on any loss.
The method is not greatly favored because it means paying away proportion of the
premium income where the direct office might safely retain the whole of risk. It is,
however, a useful method for small offices or those starting up a new class of business
where in the early days one or two heavy losses could swallow up all the income. The
method is sometimes also used between parent and subsidiary companies.
Surplus Share Reinsurance:Under surplus share reinsurance the ceding company
decides what its net retention will be for each class of business. The direct office cedes to
the re insurer only those amounts, which it does not which to should for its own account
the surplus or its retention. The re-insurer does not participate unless the policy amount

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exceeds this net retention. This retention is known also as a “line” and reinsures have a
maximum capacity of so many lines, or so many times the direct office’s retention.
For example, if the agreement calls for cession of up to “ten lines” and the direct office
retains 25,000 birr, then the times this amount can be ceded to the reinsure, i.e., 250,000
birr: in this way sums insured up to 275,000 birr can be accepted by the direct insurer
knowing that he automatically has the reinsurance he requires. It is of course not
necessary (or possible) to fill the whole capacity of the reinsurance treaty on each
individual acceptance: sometimes the acceptance will be entirely within the direct
insurer’s retention and the treaty will not be interested at all, and on other occasional the
treaty underwriters will only be ceded a limited amount which they divide equally
between them.
Using the earlier example of a ten line reinsurance treaty the position of the treaty
(reinsures) in different circumstances would be as follows:
Original Sum Direct Insurer’s Ceded to Treaty Proportion to Insured
Retention Treaty (reinsurance)
25,000 25,000 NIL NIL
50,000 25,000 25,000 50%
100,000 25,000 75,000 75%
275,000 25,000 250,000 90.9%
300,000 25,000 250,000* 83.3%
The balance of 25,000 birr would have to be reinsured facultative of under a second
reinsurance treaty.
Excess of Loss Reinsurance
In this form of reinsurance the direct insurer decides the maximum loss arising from any
event or series of events he is prepared to bear, and then arranges with re insurers for
them to pay the excess of that amount up to an upper limit. The re insurer agrees to be
liable for all loses exceeding a certain amount on a given class of business during a
specific period.

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For example, the primary insurer may be prepared to pay up to 50,000 birr any one loss,
and he secures reinsurance for the excess of 50,000 birr up to a further 200,000 the way
in which various losses are divided is shown below:
Loss Direct Insurer Excess Treaty (Re-insurer)
10,000 birr 10,000 birr NIL
50,000 50,000 NIL
70,000 50,000 20,000
100,000 50,000 50,000
250,000 50,000 200,000
300,000 100,000* 200,000
*That is its original retention of birr 50,000 birr plus a further birr 50,000 excess of the
treaty’s (reinsures) liability.
Such a contract is simple to administer because the reinsures are liable only after the
ceding company has actually suffered the agreed amounts of loss. Since the probability
of large losses is small, premiums for this reinsurance are likewise small.
Government Regulation of Insurance
Government has laid down rules governing the conduct of business, and insurance is no
exception.
In the case of insurance (as one component of business activities) special attention was
given by the government to restructure and organize it in a new form to satisfy social and
economic interests of the general public through the proclamation No. 68 of 1975, to
provide for the establishment of Ethiopian Insurance Corporation with an initial capital of
11 million dollars. Thus, the insurance industry was challenged and stimulated by the
government to do its best.
Reasons for Insurance Regulation
Insurers are regulated by the states for several reasons, including the following:
 Maintain insurer solvency.
 Equity.  Competence.
 Insurable Interest.
 Provision of certain forms of insurance.
 National Insurance.

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Maintain Insurer Solvency: Perhaps the greatest step taken by legislation was to
introduce solvency margins that were related to premium income. In this way, a ratio
was established between the margin and the amount of business undertaken. This
prevented certain people with fraudulent aims from providing insurance, and acted as a
continual monitor on those already transacting it.
Equity: The term equity has been used, but equally suitable would have been morality,
fairness or reasonableness, because each implies the fact that an element of fairness must
exist between companies and policyholders. The insurance contract is one of
considerable complexity and it is essential that controls exist for the protection of
policyholders.
Competence: The buying and selling of insurance is unlike many other forms of product
purchasing. A tangible product is not being purchased; a promise to provide indemnity,
an exact compensation, is what is being bought and sold. Those who deal in such
promises must be competent persons and able to fulfill their pledges when the need
arises. Therefore, regulations are necessary in the management of insurance and
investment business.
Insurable Interest: Insurable interest is one of the basic doctrines of insurance.
Governments have found it necessary to introduce legislation in order to eradicate any
element of gambling. It was not acceptable that unscrupulous persons could benefit by
effecting policies of insurance where they had no financial interest in the potential loss,
other than the profit they would make if it occurred.
Provisions of certain forms of insurance: An element of intervention has been in
evidence where forms of cover have been make compulsory, as the case of employers’
liability and third party motor accident injuries. The intervention is not in the provision
of cover by government, but in establishing the nature of the cover to be granted.
National Insurance: For some areas of social risk, the Governments’ intervention has
been total and it has assumed the responsibility for providing certain covers. This has
been case in areas such unemployment, sickness and widows benefits; the state carries
the risk under the National Schemes.
The Ethiopian Insurance Corporation is the sole entity, which is responsible for all affairs
and practices of the insurance industry in the country. The general objectives and

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function of the corporation being to:
1. Engage in all classes of insurance business in Ethiopia.
2. Ensure that insurance services reach the broad masses of the people.
3. Subject to government regulations and provisions, promote efficient utilization of
both material and fanatical insurance resources.
4. Enter into contract.
5. Appoint agents or act as an agent for other in matters related to its activities.
6. Manage, administer, supervise, and direct all insurance business transactions and
7. Negotiate, arrange, underwrite and contract reinsurance treaties and with foreign re-
insurers.